Annual tax paperwork has awakened many investors to the idea that it isn't always how much a fund makes that matters most. The real issue is how much you get to keep.
In the near future, funds will tell you how much their investors earned and kept, the result of a new rule that forces funds to show how tax-efficient their performance has been.
Beginning in April, the Securities and Exchange Commission is requiring funds to include after-tax return data in prospectuses. The after-tax return chart could forever alter the way many investors examine and pick mutual funds. While the extra data is a good thing, many experts worry about problems the new information could create.
At the crux of the issue is the strange way mutual funds are taxed. Funds are a "pass-through" obligation, which means that the taxes due on any profits that the fund makes trading stocks and bonds get "passed through" to shareholders.
If a fund buys a hot stock and holds it, for example, the value of the investor's shares goes up but there is no tax bill due (so long as the investor holds onto the fund). If the fund sells the stock after a year, any profit is a long-term capital gain (facing a current maximum federal income tax rate of 20 percent). If the stock is sold before a year passes, the profit is a short-term gain and is taxed at an investor's ordinary income tax rate. Dividends and interest income get taxed at the ordinary rate, too.
Funds aggregate their winners and losers and distribute them in a lump, categorizing various parts of the payout as long- and short-term gains. Shareholders must pay the tax due on that money - even if they rolled over the gains and never received an actual check - unless they hold the fund in a tax-deferred retirement or annuity account.
Studies have shown that the average fund loses about 2.5 percent of its gains per year to Uncle Sam (and his state tax-collector cousins).
That means if the fund posts a return of 10 percent, the after-tax return - what you get to keep - could be closer to 7.5 percent. And in 2000, when many funds had losses but paid out capital gains from long-term sales, the 2.5 percent average tax bite made many downturns go from bad to worse.
The SEC rule requires that prospectuses include a chart showing one, five and 10 years of after-tax returns, adjusted as if your ordinary income tax rate is the current federal high of 39.6 percent.
"There are some negatives to using the highest tax rate, but it does allow you to see how bad it could be, the worst-case scenario, which you can then compare to what happens with a fund that avoids tax hits," says Duncan Richardson, who runs the Eaton Vance Tax-Managed Growth fund. "The fund still has to produce positive results to look good; it's no great shakes to be tax-efficient if you can't achieve a pretax return."
But using the highest tax bracket in the chart is a bit misleading, since most investors pay at a lower rate, even after factoring in any applicable state taxes. The max tax calculation particularly distorts the picture on bond funds, where many lower-bracket taxpayers will be led to believe that tax-free bond funds are a superior choice, when that may not be the case.
Only money market funds and funds offered exclusively in qualified retirement plans or variable annuities are exempt from the after-tax disclosure rule.
In addition, past tax-efficiency is a poor indicator of after-tax results going forward. There is no predictive value to a fund's current tax-efficiency, making the data harder to use.
"The heightened prominence of after-tax returns suggests that some will let the tail wag the dog, selecting a fund based on tax considerations first," says Burton J. Greenwald of B. J. Greenwald Associates, a fund consulting firm in Philadelphia.
"Tax-efficiency is worth considering, but it is more of a tie-breaker, helping you pick one fund over another, rather than a key determining factor of whether a fund is right for you."
Chances are good that the fund industry will respond to the change by making some funds - those with big gains payouts - available only for retirement accounts, leaving tax-efficient offerings for people investing outside retirement plans.
That would help cure one of the ills of the fund industry, where the manager is running a pool of money for people with different objectives, some wanting maximum returns regardless of taxes, others being more tax-sensitive.
"The new rule is not perfect, but it has great potential to help mutual fund shareholders learn more about a cost to fund investing - taxes - that most don't know much about," says Joel Dickson, a principal and tax-efficiency expert at the Vanguard Group.
"Once people know what they are looking at and what the chart means, they'll be better off."
Chuck Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at email@example.com or at the Boston Globe, Box 2378, Boston, Mass. 02107-2378.